The deal gives AT&T, the No. 2 US mobile service often criticized for its poor network performance, additional capacity to expand and meet ever increasing demands for videos and data from devices such as Apple Inc's iPhone.

For Deutsche Telekom, the deal offloads an asset that was declining in profitability and provides it with funds to pay down debt and buy back shares. The German telecom operator also gets an 8 percent stake in AT&T as part of the deal, becoming its largest shareholder and retaining some exposure to the U.S. market.

The deal leaves smaller rivals like Sprint Nextel scrambling to figure out their next step. Sprint also held talks to merge with T-Mobile, the No. 4 U.S. mobile service.

Sprint complained that the deal would dramatically alter the wireless industry, which it said would be dominated overwhelmingly by two companies that have almost 80 percent of U.S. wireless contract customers.

But the world's largest M&A deal so far this year could run into trouble with U.S. antitrust officials who fear that fewer wireless players could drive up prices for consumers. T-Mobile USA now offers some of the lowest wireless services rates.

The deal will add 34 million customers to AT&T's current 96 million, giving it a combined market share of an estimated 43 percent from 32 percent, putting it well ahead of Verizon Wireless' 34.5 percent share.

It's just nuts, said David Balto, an antitrust attorney and a former policy director at the Federal Trade Commission. When you look at healthy and unhealthy markets, this is at the top of the list of unhealthy markets.

One analyst pointed out that the two top U.S. operators -- a larger AT&T and Verizon Wireless -- will account for nearly three out of four mobile subscribers after this deal, which could lead to higher bills.

U.S. Senator Herb Kohl, chairman of the Senate Antitrust, Competition Policy and Consumer Rights Subcommittee, said his panel will take a close look at what a loss of competition will mean for people who increasingly rely on wireless phone service to connect to friends, family and the Internet.

Consumers have borne the brunt of the increasingly concentrated market for mobile phone service, Kohl said.

HOPEFUL

AT&T, however, is betting big that the deal will be approved. It has agreed to pay an unusually high breakup fee of $3 billion and to give T-Mobile USA wireless airwaves if regulators reject it.

AT&T said it expected regulators to require it to sell some assets as a condition of approving the deal, which it hopes to complete in 12 months.

AT&T Chief Executive Randall Stephenson told reporters on a conference call on Sunday that AT&T had done its homework on the regulatory front and boasted that the deal could generate savings of more than $40 billion.

This is a unique opportunity. said Stephenson. It's rare you have a transaction where the synergies are greater than the price paid.

The companies have been talking for months according to sources familiar with the situation.

Stephenson reached out to Deutsche Telekom CEO Rene Obermann in December, according to one source, who said he drove the process from the AT&T side.

The substance of the deal came together over the last month, and the companies had a handshake agreement a week ago, the source said.

Deutsche Telekom looked at different options, including an IPO and a deal with Sprint Nextel before settling on the AT&T deal, a second source said. A Sprint, T-Mobile deal would have been difficult as they use different technology.

The transaction, which is Stephenson's first big acquisition since he took over as CEO, will give AT&T much needed spectrum, or wireless airwaves, to provide the capability to support surges in the delivery of video, games and entertainment to smartphone and mobile devices.

Stephenson said the company had to think differently to address an expected eight-to-tenfold increase in demand for wireless network capacity in the next five years.

Stephenson is paying a steep price for the deal. The deal values each subscriber at $1,147. At that valuation, Sprint would be worth $57 billion, almost four times its current value.

DEAL TERMS

The purchase price includes a cash payment of $25 billion with the balance to be paid using AT&T stock. AT&T has the right to pay more cash as part of the purchase price by up to $4.2 billion.

As part of the deal, which was approved by both companies' boards, a Deutsche Telekom representative will join the AT&T board. AT&T can increase the cash component so long as Deutsche Telekom retains at least a 5 percent equity stake in it.

Deutsche Telekom is expected to use 5 billion euros to buy back shares and 13 billion euros to lower its debt, said another source with direct knowledge of the deal discussions. The source said no other deals are planned in the medium term.

AT&T said that it will finance the cash portion with new debt and cash on AT&T's balance sheet. AT&T will not assume any T-Mobile USA debt and that the deal would add to earnings, excluding non-cash amortization and integration costs, in the third year after closing.

Representatives from the U.S. Federal Communications Commission and Sprint declined comment as did officials from Verizon Wireless, which is owned by Verizon Communications and Vodafone Group Plc.

(Additional reporting by Paritosh Bansal and Michael Erman in New York, Philipp Halstrick and Nicola Leske in Frankfurt and Diane Bartz in Washington D.C.; Editing by Marguerita Choy and Kenneth Li and Dhara Ranasinghe)